Case 08-3 Hedge Documentation — Cash Flow Hedge of Variable-Rate Debt


Case 08-3 Hedge Documentation — Cash Flow Hedge of Variable-Rate Debt

Case 08-3
Hedge Documentation — Cash Flow Hedge of Variable-Rate Debt

On January 1, 2010, Company XYZ (the Company) issued $100 million in five-year variable-rate bonds at par. The bonds pay quarterly interest of three-month LIBOR plus 1.75 percent. The entire principal amount is due as of the date of maturity, December 31, 2014. Simultaneously, the Company entered into an interest rate swap to hedge the exposure to variability of future interest rate payments attributable to movements in three-month LIBOR. Under the swap, which has a notional amount of $100 million, the Company pays a fixed rate of 6 percent and receives three-month LIBOR on a quarterly basis. In conjunction with entering into the swap, the Company paid a premium of $500,000 to the counterparty (the premium does not include consideration of commissions or other transaction costs). The Company intended for the interest rate swap and bonds to qualify for cash flow hedge accounting and prepared the hedge documentation shown on the next two pages.
Required:
 Identify deficiencies, if any, in the Company’s hedge documentation on the basis of the documentation requirements in ASC 815, Derivatives and Hedging.
 If any deficiencies have been identified, what is the effect on the Company’s ability to apply cash flow hedge accounting?
Case 08-3: Hedge Documentation — Cash Flow Hedge of Variable-Rate Debt Page 2
Copyright 2006 Deloitte Development LLC
All Rights Reserved.
STATEMENT 133 — DERIVATIVE DESIGNATION SUMMARY
Business Purpose/Hedging Strategy This swap converts our variable-rate bonds into a fixed-rate obligation. The purpose of entering into this swap is to reduce our exposure to changes in interest payments attributable to changes in the three-month LIBOR and is within our policy guidelines. The hedge complies with our accounting and risk management policies in terms of the instrument and the counterparty used. It is also consistent with our stated corporate risk management principles.
Hedging Instrument and Hedged Item
Interest Rate Swap Bonds
Trade date January 1, 2010 January 1, 2010
Effective date January 4, 2010 January 4, 2010
Maturity date December 31, 2014 December 31, 2014
Notional amount $100 million $100 million
Fixed interest rate 6% N/A
Variable interest rate 3-month LIBOR 3-month LIBOR + 1.75%
Settlement and interest
payment dates
End of each calendar quarter End of each calendar quarter
Reset dates End of each calendar quarter
through September 30, 2014
End of each calendar quarter
through September 30, 2014
Counterparty ABC Bank Various
Nature of Risk Being Hedged Interest rate risk (i.e., the risk of changes in the future cash flows relating to interest payments on the $100 million bonds because of changes in three-month LIBOR).
Effectiveness Assessment The critical terms of the interest rate swap and bonds are the same (i.e., same notional, same maturity, same benchmark interest rate, and same reset date). Accordingly, the hedge of the interest payments of the variable-rate debt with a pay-fixed, receive-variable interest rate swap, in which the variable leg is based on the same index as the variable rate of the debt, is expected to be highly effective at inception and on an ongoing basis. As a result, no prospective and retrospective effectiveness assessment will be performed.
Ineffectiveness Measurement No ineffectiveness will be recorded in earnings because the hedging relationship qualifies as highly effective (see documentation under “Effectiveness Assessment”).
Case 08-3: Hedge Documentation — Cash Flow Hedge of Variable-Rate Debt Page 3
Copyright 2006 Deloitte Development LLC
All Rights Reserved.
ASC 815 (Statement 133) Accounting Treatment
Type of Hedge (Fair Value, Cash Flow, Foreign Currency)? Cash Flow Because it qualifies as a highly effective cash flow hedge, the swap will be reported on the balance sheet at fair value, with changes in fair value recorded in other comprehensive income. Any gains or losses accumulated in other comprehensive income will be reclassified into earnings in the same period during which the hedged item affects earnings (i.e., as the Company makes its quarterly interest payments on the bonds).
Prepared by: Suzie Smith Date: January 11, 2010
Reviewed by: Robert Jones Date: January 11, 2010

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